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Alan Haft

Insights into a possible stock market storm ahead

What would happen to your clients dividend stocks should the Bush tax cuts expire?

May 21, 2012
by Alan Haft

I’m far from being a tax or market psychic, but in the likelihood the 2003 Bush tax cuts do expire at the end of this year, there’s a long list of tragedies that are likely coming along with it.

Pain, suffering, and carnage are the first things that come to mind. Here’s one other thing I think many of your clients should likely know about.

Dividend stocks

I work with a lot of people who invest in dividend-paying stocks. While their stocks hopefully grow in value, they also like the cash payments that come with it.

Example: At the moment I write this, General Electric (GE) currently pays a reliable dividend of $0.68 per share (current price of $19.01). Suppose you and I buy a GE house today for the price of $19.01. Unless we sell the house at a gain, we get no cash while owning it. But the good news is that while we own it, there’s guy living in it paying us rent of $0.68 each year while he lives there.

As long as he continues paying his rent, we’re getting his $0.68, regardless of what happens to the value of the house.

It’s important to understand that the value of our “house” can either rise or fall, but independent from this value, we can expect to get paid $0.68 for the house we own for as long as we hold on to it.

That’s the good news about generally reliable dividends; for any number of reasons, the cash payments are attractive to many market investors.

Taxes and risk

To make things a bit more pragmatic, when doing the math, GE’s $0.68 dividend translates into a current yield of 3.6%. Therefore, if today I buy $100,000 worth of GE stock, I can expect to receive an annualized cash payment of around $3,600.

But is this dividend really mine?

Of course not! Obviously, I have to pay taxes on it. Current rates for qualified dividends are at 15%. So in a vacuum and not assuming possible offsets, I would have to pay Uncle Sam somewhere around $500 in tax, making my net return somewhere in the ballpark of not 3.6%, but a little lower at roughly 3%.

Three percent in this ultra-low-interest environment? Not so bad.

But hold on a second …

Something else needs to be factored in here: that little thing known as risk. After all, we’re talking about owning a stock here, so I certainly need to factor in the risk that the value of my GE house, which may very well rise and fall. Looking back over this last decade or so, I can see this house was worth around $60 at its high and around $10 at its low. So, it’s certainly had its share of ups and downs.

Factoring in all of this along with the global economy, GE’s earnings, its prospects, and of course, its attractive net 3% dividend, the market has deemed $19.01 as its current fair market value.

$19.01 may seem like a fair value today, but let’s fast forward to what happens after the Bush tax cuts likely expire. Assuming taxes on these dividends do shoot up to the estimated possible rate of somewhere around 40%, suddenly the perceived fair market value of its price will very likely be adjusted as well.

Here’s why:

Remember GE’s current “net” dividend yield of around 3%? With this expected higher tax rate on dividends, an investor’s net return would go down to around just under 2%.

At this point in time, investors will very likely want their net 3% dividend back and unless GE gives us a big gift by significantly raising their dividend, the only way an investor is going to get it back is by selling until current perceived “fairness” returns.

After all, when investors see a significant drop in net dividend yields, many sell and look elsewhere to invest. Keep in mind: these days when an investor can get around 1% yield on very safe investments, is an extra point of return really worth the risk of investing in a stock?

Assuming people sell, demand obviously goes right down with it, along with the stock’s value. When its price falls low enough, the math to calculate the dividend yield should indeed return to the current level your client now receives. And at that point, investors might very well return to the stock and thus stabilize its price from further drops.

Sound a bit complicated? I’ll try making it a bit simpler:

Assuming the Bush tax cuts do expire and dividends are taxed at somewhere around 40%, GE stock would need to drop roughly 30% off its current price for an investor to feel they’re being fairly compensated for the same risk they’re taking while owning it today.

This translates into a drop from its current price of $19 to around $13 per share.

Ouch.

Should this happen, who would want to be invested in GE at that time? I certainly wouldn’t. After all, one needs around a 40% gain in order to make back a 30% loss.

Furthermore, ripple this across all companies that pay attractive dividends and watch out. Along with whatever turmoil of the day that may exist, there could very well be a sharp increase in market volatility.

Will this happen? … Who knows? Depending on many possible factors, it very well might not, but one thing is for sure, just the awareness of what might possibly lie ahead could mean a big difference in helping your clients protect their hard earned money.

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Alan Haft is an investment adviser representative with an insurance license, author of three books, including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television, and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek, and many others.

For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage-based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product.